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Missing the Points?

Did you buy a home or refinance a mortgage? There may be a deduction in your future.

With the flurry of new home purchases and refinanced mortgages, a brief discussion on the tax treatment of loan points might be in order. (And if you haven't looked into refinancing lately, now is the time to possibly save big bucks.) Understand that "points" (you may see them called "loan origination fees," "maximum loan charges," "loan discount," "discount points," or simply "points") are nothing more than interest that you're paying up front on your new loan.

Since points actually represent an interest expense, they are tax-deductible. But the challenge is to figure out how to treat the points paid: as an immediate deduction (i.e., you report the full amount in the year of payment) or an amortized deduction (i.e., spread out over the life of the loan).

To show the difference, let's look at an example of amortization. Pam incurs $1,800 in loan points on July 1, 2002 -- the closing date of her loan. Pam determines that she must amortize her points. The loan is scheduled to run for a period of 30 years. For the first year, Pam will deduct $30 in interest expense in the form of amortized points. She makes this computation by taking the amount of the points ($1,800) divided by the length of the loan (30 years). That gives her a result of $60, which represents the annual amortization expense for her interest points.

For the first year, Pam also has to take the annual amount ($60) and divide it by the number of months in the year (12), and multiply that result by the number of months the new loan was in force (six). That gives Pam a result of $30, which is the interest deduction on her mortgage points for the half-year that the loan was in force.

The challenge you face is determining when points can be fully deducted and when they must be amortized. In order to receive an immediate and full deduction for points paid on your loan, all of the following requirements must be met:

The settlement or loan statement must clearly identify the amount of the points. They may be called "loan origination fees," "maximum loan charges," "loan discount," "discount points," or simply "points."

The points must be computed as a percentage of the principal amount of the loan.

The amount paid as points must not exceed the normal rates charged in the area. Any additional amount paid must be deducted over the life of the loan. This would include "buying down" the interest rate on your loan by paying additional points. The normal points would be deductible, while the additional points would be deducted over the life of the loan.

The points must be paid on a loan to purchase or build your principal residence. Not only that, the loan must be secured by that residence. So if you pay points to purchase a second residence, those points must be deducted over the life of the loan.

The points must be paid directly with your own funds. They can't be financed. But understand that down payments, escrow deposits, earnest money, and any other funds paid at the closing will count as payment of points as long as these amounts are as much or greater than the points charged. If the points are paid from the loan proceeds, they must be deducted over the life of the loan.

You must use the cash method of accounting (which virtually all of us use).

(Note: "Loan origination fees" designated as such on Veterans Administration and Federal Home Administration loans qualify as deductible points if the requirements above are met.)

Now, let's look at deductibility of some specific types of points.

Home improvement loan points: Points paid on a loan to improve your principal residence are also fully deductible in the year paid if the requirements above are met. For example, if you take out a new or additional loan to improve your principal residence (not your second residence), then the points you pay (and don't finance) can be fully deductible in the year paid as long as the general point requirements are met.

Seller-paid points: Homebuyers are allowed to deduct seller-paid points as an itemized deduction on Schedule A. The seller is treated as having paid the amount of the seller-paid points to the buyer, who in turn is treated as having paid the points charged by the lender. There are, of course, restrictions to this general rule. To qualify as deductible seller-paid points, all of the six requirements noted above for normal points must be met. In addition, the closing statement must clearly indicate a credit given for points paid by the seller.

Refinance points: If you refinance a loan to get a lower interest rate, or for just about any other reason, it's possible that you'll get hit with points. These loan points must be deducted (amortized) over the life of the loan. It makes no difference if you actually pay or finance the loan points -- they will still be required to be amortized.

However, if you refinance your loan and borrow additional funds, and you use some of those additional loan proceeds to substantially improve your primary residence, a portion of the loan points paid may be deductible in full in the year that they are paid.

Take the case of Emily and Joe, who have a mortgage loan balance of $42,000. They decided to refinance the original loan, borrowing $60,000 so that they'd have an additional $18,000 to put a second story on their principal residence. They paid $2,000 in points on the refinancing. Since they actually paid the points (and didn't finance them), they will be allowed to deduct 30% of the total points (or $600) in full in the year that the points were paid. How did they arrive at 30%? By taking the amount of the loan used to improve the property ($18,000) and dividing it by the total amount of the new loan ($60,000). The remaining $1,400 in points would be required to be deducted (amortized) over the life of the loan.

Home equity line of credit points: Points paid for a line of credit or "equity line," which is secured by the home, are deductible over the period of time that the credit line is in effect. However, like other points, if the funds from a line of credit are used for improvements on your primary home, they are fully deductible in the year that they are paid.

Deducting the unamortized balance of pointsIf you find that you must amortize your points, don't despair. Remember that an unamortized balance of the points can be immediately deducted if and when the loan is completely repaid.

Let's revisit our first example above. Same facts: Pam was required to amortize her loan points over her 30-year loan that closed originally on July 1, 2002. For 2002, Pam receives an amortized points deduction of $30. For 2003 and 2004, Pam receives an amortized interest deduction of $60 each year. So, at the end of 2004, Pam has an unamortized balance of $1,650 (the original $1,800 in points, less the points actually deducted in prior years of $150).

Pam decides to again refinance her loan, thereby getting a new loan to pay off the old loan and securing a lower interest rate. On Jan. 5, 2005, the new loan closes, and the prior loan is repaid in full from the proceeds of the new loan. Since the prior loan was paid in full, Pam can take as a deduction the remaining unamortized balance of those points. So on her 2005 tax return, Pam can deduct the remaining unamortized points in the amount of $1,650. And this is in addition to any new loan points that she may also be required to amortize over the life of the new loan.

Points can get complicated, but once you know the rules and can apply them correctly, you'll find that the deduction for points, no matter how you take them, will help to reduce your taxes. So be careful not to miss the point!

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.